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Liberalization in Reverse

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The year 2008 marked the 30th anniversary of the beginning of market reforms in China -- and perhaps the third anniversary of their ending. Since the present Chinese leadership took power, market-oriented liberalization has been minor. And as such policies have wound down, they have been supplanted by renewed state intervention: price controls, the reversal of privatization, the rollback of measures encouraging competition, and new barriers to investment.

Why would China, with a generation of successful market reform under its belt, move back toward state control? Because of politics run amok. When the administration of President Hu Jintao and Premier Wen Jiabao assumed control seven years ago, they acted like any new Chinese regime: they moved to solidify their power through economic stimulus. Only they did not stop. Soon after they took office, lending by state banks and investment by local and national state entities soared. Helped temporarily by very loose global monetary conditions, the Chinese state did well by most economic standards. And success created a constituency in political and business circles that is obsessed with growth at the expense of all else. This growth today is explicitly led by the state, fueled by investment by state-owned entities, and accompanied by powerful regulatory steps meant to ensure the state's dominance of the economy -- all measures that contrast sharply with prior reforms.

The Chinese Communist Party no longer sees the pursuit of further genuine market-oriented reform as being in its interest. The burst of growth that the economy exhibited after the initial state-directed stimulus convinced the CCP that true liberalization is now unnecessary as well as sometimes painful. Whatever the objectives of the Obama administration, it must realize that it will be difficult to change Beijing's views quickly. True broad-based market-oriented reform in China should remain a long-term goal of U.S. economic policy. But for now, the Obama administration would do better to focus its economic diplomacy on evaluating and responding to the Chinese government's strategy of aggressively promoting state-led growth. It should not presume that Beijing will return to market reform anytime soon.

The U.S. government cannot afford to get this wrong. Because of the increasing pressure of the global economic crisis, some have called for a policy of partial disengagement. But the U.S.-Chinese relationship is the most important bilateral economic relationship in the world. Together, the United States and China accounted for more than 30 percent of the world's GDP in 2007. In 2008, bilateral trade stood at $409 billion -- dwarfing the $206 billion worth of trade between the United States and Japan -- and Chinese exports to the United States amounted to approximately 7.7 percent of China's GDP. At the end of 2008, Beijing was the largest holder of U.S. Treasuries, with over $700 billion in reserve.

Even incremental improvement in a relationship of this magnitude would have a large economic payoff, all the more so given the recent collapse of the global financial system. This crisis arose in part from imbalances in the U.S.-Chinese economic relationship. (Beginning in late 2002, U.S. monetary policy stimulated already excessive U.S. demand, which served as an even bigger outlet for already excessive Chinese supply. Beijing directly contributed to the prevalence of loose money in the United States by recycling dollars earned from trade into U.S. bonds, a strategy arising from Beijing's decision to keep China's capital account closed and the yuan not freely convertible.) At the same time, the situation could get considerably worse if attempts to rectify those imbalances are made too quickly or using the wrong methods. Washington is worried about its ability to continue financing public spending at home, and China, because of the U.S. bonds it holds, is important to that effort; Beijing is worried about maintaining its exports, growth, and, ultimately, high employment, and the U.S. market is crucial to that. The financial crisis has only raised the stakes of getting the U.S.-Chinese economic relationship right.

The question is how best to engage China. Free trade offers opportunities and choices to businesses and consumers; Protectionism limits both. The 1930 Smoot-Hawley tariffs are an unforgettable reminder that it would be especially dangerous in the current environment for President Barack Obama to move away from open trade. And so he must engage China -- only he must do so while reorienting U.S.-Chinese trade policy in light of Beijing's lack of interest in discussing issues such as its subsidization of state enterprises and its apparent decision to halt market-oriented reform. Washington should encourage the Chinese to focus on a narrow range of feasible measures. Energy, the environment, and bilateral investment are fine topics for bilateral negotiations, but the agenda should be restructured to emphasize a series of meaningful reforms designed to, for example, liberalize prices, curb state dominance in corporations, shield U.S. companies from mercantilist measures, and allow money to move freely in and out of China. This will be a far more difficult and protracted process than casual calls for the creation of a G-2, or a high-level, informal forum for discussion, suggest. The first step is to understand the true state of the Chinese economy and thus what can be expected of it.

THE VISIBLE HAND

State involvement in the Chinese economy is nothing new -- it was a feature even during the reforms under Deng Xiaoping. In 1998, in the wake of the Asian financial crisis and while China was making a bid to join the World Trade Organization, President Jiang Zemin and Premier Zhu Rongji understandably sought to boost investment by Chinese state entities. The difference under Hu and Wen in 2002-8 was that their administration relentlessly advanced the state's role in the economy despite the absence of an economic slump. But with the concessions needed to accede to the WTO -- for instance, lower tariffs -- largely implemented by 2005, the state's more recent advance has effectively forced the market's retreat. It might seem natural under the present crisis for the Chinese state to extend its reach into the economy, but it has been doing so for years.

Former U.S. Treasury Secretary Henry Paulson, a perennial optimist, wrote in September 2008 that "China's leaders today are committed to reform, at least so long as it improves the country's political and economic stability." But this is true only if one accepts a very dubious definition of "reform" and ignores overwhelming evidence that reform has stopped. Price liberalization, the core of market reform, has been partly undone. privatization was stalled at first and then explicitly reversed. Initiatives to increase corporate competition are also being rolled back. The Chinese state is increasingly encroaching on even the relatively open external sector by restricting incoming investments and imposing taxes on exports.

The central government has recently reversed the outstanding progress in the liberalization of prices that China made during the first two decades of reform. The price of labor (wages) remains largely free from government interference, but that is manifestly not the case with the price of capital (the interest rate), for which the People's Bank of China sets a compulsory and narrow range. Government intervention constantly distorts the prices of basic assets, such as land, often by simply forbidding or promoting transactions. The State Council sets and resets the prices for all key services: utilities and health care, education and transportation. Although the exchange rate has been loosened up over the past three years, the People's Bank of China sets the daily value at which the yuan must be traded against the dollar. And currency fluctuation is still starkly limited: the daily movement of the yuan against the dollar is not allowed to exceed 0.5 percent. The market in China has never really determined the sale prices of many ordinary goods by itself, and the tendency over the past few years has been to further extend price controls for goods. The state's complete control over grain distribution has distorted wholesale grain prices; a recent bout of inflation has prompted restrictions on the prices of retail food as well. The energy sector has always been tightly regulated. The government applied price ceilings for coal and oil products, such as gasoline, as global crude-oil prices spiked during the first half of 2008 and then lifted them once prices receded. The newest plan for the energy sector, issued by the State Council in late 2007, reserves the state's absolute right to set prices.

Likewise, although some Chinese state assets were privatized during the reform era, especially during the mid-1990s, liberalization has never been extensive, and in the third decade of reform, it faded. During 2006 alone, the number of individuals who owned businesses fell by 15 percent, to 26 million -- a pittance given the country's total population of more than 1.3 billion. The latest official data publicly released show that truly private companies contributed less than ten percent of national tax revenues during the first nine months of 2007 and that the figure dropped in the first part of 2008.

Examining what companies are truly private is important because privatization is often confused with the spreading out of shareholding and the sale of minority stakes. In China, 100 percent state ownership is often diluted by the division of ownership into shares, some of which are made available to nonstate actors, such as foreign companies or other private investors. Nearly two-thirds of the state-owned enterprises and subsidiaries in China have undertaken such changes, leading some foreign observers to relabel these firms as "nonstate" or even "private." But this reclassification is incorrect. The sale of stock does nothing by itself to alter state control: dozens of enterprises are no less state controlled simply because they are listed on foreign stock exchanges. As a practical matter, three-quarters of the roughly 1,500 companies listed as domestic stocks are still state owned.

No matter their shareholding structure, all national corporations in the sectors that make up the core of the Chinese economy are required by law to be owned or controlled by the state. These sectors include power generation and distribution; oil, coal, petrochemicals, and natural gas; telecommunications; armaments; Aviation and shipping; machinery and automobile production; information technologies; construction; and the production of iron, steel, and nonferrous metals. The railroads, grain distribution, and insurance are also dominated by the state, even if no official edict says so. In addition, state enterprises draw their top executives from the same pool as does the government. Chinese officials routinely bounce back and forth from corporate to government posts, each time at the behest of the CCP.

Moreover, the state exercises control over most of the rest of the economy through the financial system, especially the banks. By the end of 2008, outstanding loans amounted to almost $5 trillion, and annual loan growth was almost 19 percent and accelerating; lending, in other words, is probably China's principal economic force. The Chinese state owns all the large financial institutions, the People's Bank of China assigns them loan quotas every year, and lending is directed according to the state's priorities.

This system frustrates private borrowers. They might try to raise funds by selling bonds or stocks, but these sales are dominated by the state, too. The volume of bonds issued by the government is more than a dozen times that of bonds issued by corporations; private firms are crowded out. There was a wild bull run on domestic shares in 2006 and 2007 after the government decided to boost the stagnant stock market. But its means of doing so left a huge number of state-owned shares temporarily untradable. With those trading lockups expiring over the course of 2008, a flood of state shares again loomed large over the market, and prices crashed back down to earth. A stock-market rally in early 2009 seemed driven largely by high liquidity; it left the Shanghai Composite Index in late February 66 percent below its peak of October 2007.

REFORM ROLLBACK

One reason the rollback of reform has been overlooked by Washington is that China is officially engaged in a process of restructuring its economy. But this effort has none of the characteristics of market reform. It is aimed at shrinking the number of participants in many industries and expanding the size of the remaining enterprises; through both measures, it will reduce competition. This is not a strategy unique to China: Japan and South Korea have also created so-called national champions, supporting large corporate groups with the idea that their size will make them competitive on the global market. An unspoken corollary of this policy is that private domestic and foreign firms often are prevented from competing with these privileged firms. China has been enamored of the concept of national champions for at least a decade, but even more so since the ascent of Hu and Wen.

The results of this restructuring have been striking. Since the highly publicized contraction of the telecommunications industry from four firms to three, there are now only 17 national enterprises in the oil and petrochemicals, gas, coal, electric power, telecommunications, and tobacco sectors combined. First Aviation Industry and Second Aviation Industry merged; apparently, two firms in that sector was one too many. From cement to retail, all areas are consolidating. Rather than permitting competition to drive down the windfall profits from crude oil and drive out inefficient oil-product suppliers, for example, the National Development and Reform Commission raised taxes on crude for the three state oil giants -- which together constitute the entire crude industry -- while subsidizing them in the refining sector, where they face small competitors. The state now plays a central role in all oil-related activities in the country.

Economic freedom has also been curtailed by mounting barriers to foreign direct investment (FDI), which began to be erected in late 2005. New FDI transactions began to dry up in 2006 and, save for a few monthly blips, were scarce even before the current economic crisis. Happy official results are distortions. According to government figures, FDI in China rose by more than 13 percent in 2007. The European Union, however, reports that its investment in China plunged from about $7.9 billion in 2006 to about $1.5 billion in 2007. The official FDI figures were driven by funds repatriated by domestic enterprises through Hong Kong and offshore capital centers. And that money was not very productive. The Ministry of Commerce estimated that during the first five months of 2008, total FDI was 55 percent higher than during the same period in the previous year, but investment in fixed assets, where spending has a visible effect, fell four percent over the same period. The increases in FDI in 2008 were largely the result of financial speculation rather than an effort to develop new technologies or create desirable jobs.

This lack of genuine FDI is no accident: Beijing deliberately decided to restrict market access. Its mercantilist tendencies intensified sharply in the fall of 2005, as reflected in the discussion of the sale of minority shares in state banks at the plenary meeting of the CCP's Central Committee. Then, the pathbreaking acquisition in October 2005 of the state-owned Xuzhou Construction Machinery Group by the Carlyle Group, a U.S. private equity firm, was reversed. Several sales that had previously been approved were vetoed at the March 2006 meeting of the National People's Congress. Additional industries were designated as "strategic" and thus made off-limits to foreign investors. During the CCP's plenary meeting in the fall of 2006, this limitation morphed into an outright ban on any type of FDI that threatened "economic security" -- a concept that was never defined.

Prior to the March 2007 meeting of the National People's Congress, the Ministry of Commerce formalized the requirements for foreign acquisitions, which allowed the ministry to ban any proposed purchase that allegedly harmed either China's economic security or its state assets. The first criterion has the effect of walling off entire sectors of the economy from foreign buyers; the second allows many offers to be rejected as unacceptable. In times when stock prices were soaring, Chinese regulators have said that foreign bids were undervaluing state firms compared to the market. But when share prices have been low, the government has blocked deals on the grounds that the market price was undervaluing state firms. No famous domestic brand can be acquired, and it is the Ministry of Commerce that decides what makes a brand famous -- and usually after the offer to buy it has been made. The list of sectors that are regulated in this fashion is even longer than that of sectors the state insists on controlling.

Two recent laws that have been touted as market reforms will in fact place yet more limitations on the activities of foreign companies in China. The new labor law, aimed at enhancing workers' rights, is being implemented by the All-China Federation of trade Unions, a xenophobic organ of the CCP that has uniformly ignored abusive behavior by state firms while periodically assailing foreign firms for comparatively minor violations. Despite its nominal purpose, the new antimonopoly law will not promote competition either. Designed to protect "the public interest" and promote "the healthy development of the socialist market economy," it forbids firms with dominant market shares from buying or selling goods and services at "unreasonable" prices, but it neither defines a market nor offers any method for identifying what is unreasonable. Most telling, the antimonopoly law contains exceptions for all industries controlled by the state and all industries deemed important to national security. It further requires that proposed acquisitions by foreign investors be subjected to both a review on national security grounds and an antitrust probe. Such screenings exist in many countries, but with the CCP's exceptionally broad definition of "national security," these are exceptionally sweeping. Also distressing, regulators can suspend or limit intellectual property rights if they deem these to have been abused in the service of creating a monopoly. The Chinese state has long considered many patents unfair, but now it has the legal means to act against them. The government can wield the antimonopoly law against foreign companies or governments that seek to protect intellectual property, as did the U.S. government before the WTO in 2007 and the French company Danone against the China Patent and Trademark Office in 2008.

TRADING FACES

The problems regarding trade are less subtle. If China's export trade remains largely open and competitive, its import trade still faces some nontariff barriers intended to protect state prerogatives or shelter vital industries, such as energy and agriculture. And then there is the main point of contention in U.S.-Chinese trade relations -- in fact, in the entire economic relationship -- the exchange rate. The reason for the issue's contentiousness is its visibility: persistently large trade surpluses for China should push the value of the yuan higher, but this has not occurred because the People's Bank of China fixes the price of the currency. A broad restarting of financial reform in China would have enormous benefits for the United States -- one of which would be a looser hold on the exchange rate by Beijing. Merely liberalizing the exchange rate by itself, however, would not necessarily benefit the United States.

After a 2.1 percent revaluation in July 2005, the yuan climbed by 16 percent against the dollar, peaking almost exactly three years later. But over the same period, it fell six percent against the euro. While the yuan stagnated against the dollar during the second half of 2008, it soared against the euro, at one point climbing 14 percent in just a few weeks of October. In other words, the yuan may be undervalued against other major currencies even more so than it is against the dollar. Thus, it is not clear that allowing a wider daily trading band and calibrating the yuan against a trade-weighted basket of currencies -- two stated U.S. goals -- would lead to a short-term appreciation of the yuan against the dollar.

An apparent alternative would be for Washington to demand a much larger one-time revaluation to increase the value of the yuan either across the board or against the dollar alone. But this would probably only sidetrack negotiations -- and for little benefit. During the first six months of 2005, when the exchange rate was still entirely fixed, the United States ran a $90 billion trade deficit with China. But then, during the first half of 2008, when the yuan neared its peak value against the dollar, the trade deficit exceeded $115 billion. In other words, a more expensive yuan did not prevent the trade imbalance from widening. Although a freer exchange rate is in the United States' interest in the long term because it would dampen trade imbalances, the Obama administration should be careful what it wishes for now.

A more promising approach to U.S.-Chinese trade issues would be to encourage Beijing to liberalize its capital account, which would allow money to move freely in and out of China. (Together with the current account -- the balance of exports and imports of goods and services -- the capital account makes up most of a country's balance of payments.) It was once assumed that the difficult process of liberalizing China's capital account would occur naturally as the country started complying with the conditions for its accession to the WTO; an open capital account was to be ratified no later than during the 2007 Communist Party Congress. But there has been no progress, and perhaps even a regression, under the Hu-Wen regime. Beijing has showed little interest in allowing multinationals, much less Chinese citizens, to freely send earnings or savings out of the country.

Because capital-account liberalization would allow for the unfettered repatriation of profits, the U.S. business community has long advocated it. But it also offers a less obvious and more important benefit: by forcing financial policy to respond to market behavior, it could considerably reduce state intervention in the Chinese economy. An open capital account would permit capital to exit China, which would constrain the behavior of Chinese banks by draining off some of the guaranteed deposits they now enjoy. That, in turn, would inhibit the type of state-directed lending that has effectively been blocking privatization and subverting competition. Although such liberalization is still far in the future, it is worth pushing for it now.

GROW, GROW, GROW

Market reform has died out in China in part because the country's leaders have pursued GDP growth at the expense of all else. This decision has had its upsides: were it not for China's remarkable economic performance over the past three decades, and especially between 2002 and 2008, the country would not be treated as a major economic player. Although export weakness has been the subject of much gnashing of teeth in Beijing, the trade surplus was at $295 billion for 2008 -- another annual record on the tail of consecutive monthly surplus records from August through November of that year. According to the Chinese National Bureau of Statistics, between June 2002 and June 2008, China's GDP more than tripled and its exports more than quadrupled. (The nine percent increase in GDP for the whole of 2008 was considered dangerously slow in comparison.) This rapid GDP growth has created jobs: by the end of June 2008, the unemployment rate among registered urban voters was a mere four percent -- even lower than the government's ambitious target of 4.5 percent. That figure may understate true joblessness by ignoring rural and unregistered urban employment, but it accurately reflects trends in the broader job situation. So many migrant workers from rural areas were absorbed into the urban labor force that the 20 million such workers reported to have lost their jobs in late 2008 still left well over 100 million rural migrants with jobs in cities. Urban wages have climbed significantly, by 18 percent between 2007 and 2008 (unadjusted for inflation) according to official data. The payoff of the wage increase was a 21 percent growth in retail sales (also unadjusted for inflation) during that period.

Of course, there were some drawbacks to six years of furious expansion. Most visible were food and energy inflation. According to official figures, food inflation peaked at 21 percent in April 2008 and energy inflation at a frightening 30 percent in August 2008. Moreover, these official results understated the effects of inflation because price controls on energy have always been in place and were extended to food. Yet even as GDP growth reached and stayed in double digits, job creation surpassed its target, and inflation spiked, fiscal and monetary policies remained intensely expansionist. At the peak of growth, in 2007, monetary policy became increasingly loose, and when GDP growth moderated in 2008, the government rushed to provide fiscal stimulus.

In 2007, inflation-adjusted "real" interest rates began to turn negative -- the ultimate sign of a perverse monetary policy -- and then became more starkly negative during the first quarter of 2008. The benchmark one-year interest rates set by the People's Bank of China for borrowing and saving remained fixed despite considerable inflation. At the end of June 2008, official consumer price inflation and producer price inflation were both close to eight percent, whereas the return on a one-year deposit was barely four percent. The January 2008 interbank bond yield was 2.81 percent, and after six months of purported monetary contraction, the July 2008 interbank bond yield was 2.76 percent. Before the financial shock, while the growth rate was still in double digits and the rate of inflation was climbing toward double digits, Beijing was trying to stimulate the economy further.

As consumer inflation began to ebb due to the crisis, real interest rates became less distorted. But this happened while the government was further opening the fiscal tap. China's urban fixed investment accelerated sharply, rising by 28 percent in the first three quarters of 2008. Its gain for the year as a whole ended up at 26 percent due to much weaker real estate investment at the end of year. Beijing has been determined to move investment growth higher. "We need to actively boost domestic demand, to maintain steady economic growth," said the economist Wang Tongsan, of the Chinese Academy of Social Sciences, in August 2008. "Investment is an indispensable part of boosting domestic demand." This would have been a reasonable position if the baseline from which domestic demand were to be boosted had not been a GDP growth rate above ten percent and if the means of such boosting had not been urban investment growth, which was already at more than 25 percent.

These features suggest that U.S.-Chinese cooperation on energy and environmental concerns may be much more difficult than commonly thought. China wants to protect its environment and shift to cleaner energy sources. But the terrible distortion of its financial system and its excessive investment growth maintain production at levels that consume massive amounts of energy and deplete the environment. And the Chinese leadership is eager to push GDP growth back up to double-digit rates for the sake of creating jobs. In 2007, China began reporting modest increases in energy efficiency and slower rates of degradation in select air- and water-pollution measures. But these have been, and will continue to be, overtaken by economic growth. For example, Beijing has spent lavishly on nuclear, gas, and wind power in an attempt to diversify the country's energy sources and move away from coal, and it has tried to close small coal mines. Yet coal production jumped from 525 million tons in 2002 to a staggering 1.26 billion tons in 2008. And in August 2008, the State Council emphasized the need for greater annual coal output to support greater industrial production.

GETTING TO YES

With China's economic policy largely beyond Washington's reach, the most the Obama administration can control is how to engage the Chinese government. Fortunately, an effective framework for doing this already exists: the Strategic Economic Dialogue (SED), which was created by executive orders by George W. Bush and Hu in September 2006 to complement an increasingly ungainly clutter of high-level bilateral institutions. These include the Joint Commission on Commerce and trade, which involves the U.S. Department of Commerce, the U.S. trade representative, and China's vice premier for trade; the Joint Commission Meeting on Science and Technology, which involves the director of the U.S. Office of Science and Technology Policy and the Chinese Ministry of Science and Technology; and the Global issues Forum, led by the U.S. State Department and the Chinese Ministry of Foreign Affairs.

With the world's two largest economies facing so many common and clashing interests on so many issues -- trade, investment, energy, the environment, health, and scientific research -- such an institutional jumble is only natural. Discussions on traditional economic matters alone require the involvement of the Joint Commission on Commerce and trade, the Joint Economic Committee, and the Economic Development and Reform Dialogue. This means, on the U.S. side, the involvement of the Departments of Commerce, State, and the Treasury and the trade representative and, on the Chinese side, the involvement of a delegation headed by a vice premier and representatives from the Ministries of Commerce and Finance and the National Development and Reform Commission. Any one issue involves input from several departments: the question of capital-account liberalization, for example, concerns the U.S. Departments of Commerce and the Treasury and the U.S. trade representative as well as the Chinese Ministry of Commerce, the People's Bank of China, and the National Development and Reform Commission.

It is important that the objectives of different departments be coordinated and that a higher authority be able to negotiate across issues that, if taken individually, might seem intractable. This is the proper role of the SED. Even if Obama favors a more direct and aggressive approach toward China than is currently possible with the SED's tangled and ponderous ways, it would be advantageous to be able to raise the stakes of, say, a dialogue on energy policy by holding it within the SED or another institution at a similar level. The SED should be maintained or an equivalent body created.

On the other hand, the U.S. Department of the Treasury should no longer play a leading role in the institution; this undercuts the SED's principal benefits by limiting its reach to that of one cabinet official. The counterpart of a U.S. cabinet secretary is a Chinese cabinet minister, a relatively low position in the CCP hierarchy. Thanks to U.S. efforts, a Chinese vice premier has already become involved in the SED. It would be ideal if the Chinese premier, who heads the State Council and thus all of the relevant bureaucracies, would take the lead in representing China in such discussions. Likewise, the U.S. vice president should be granted real authority to negotiate on behalf of the United States. Short of that, an especially powerful cabinet secretary -- from the Treasury, the Commerce, or the State Department -- should be given an additional title pertaining to economic policy or China. That would encourage the Chinese government to empower a vice premier to make difficult concessions. U.S. Secretary of State Hillary Clinton is an ideal choice: she is considered by the Chinese not only to hold a relevant position but also to be more than just a cabinet secretary. In contrast, U.S. Treasury Secretary Timothy Geithner does not have with Beijing even the clout that former Treasury Secretary Paulson did, who was considered to be a devotee of the U.S.-Chinese relationship.

SED talks should focus on obtaining from the Chinese leadership an explicit long-term commitment to liberalizing interest rates, exchange rates, and energy prices. This would go some way toward addressing China's underlying economic distortions rather than just a few of their manifestations. Instead of asking an unreceptive audience for sweeping privatization, the Obama administration should pursue more pragmatic and manageable improvements. And it should be forceful in going about this. For example, it should threaten to file complaints with the WTO over the pernicious effects of the Chinese state's dominant role in the economy if the central government does not make transparent its support for state-owned enterprises, especially larger ones.

The Obama administration should also seek from Beijing a formal commitment that it will open state-dominated companies to foreign investors, even if Beijing insists on some limits. Washington should switch its emphasis from getting Beijing to liberalize its exchange rate to convincing it to liberalize its capital account, and Washington should ask Beijing for a full schedule of steps it will take to open its capital account. The U.S. government should also emphasize that the discriminatory application of China's new labor and antimonopoly laws against foreign companies is unacceptable. Only after satisfactory results in these areas are achieved can there be progress toward a bilateral investment treaty.

Some current U.S. objectives fly in the face of Beijing's state-dominated model of development, which the Chinese government has deemed to be very successful. Only modest progress can therefore reasonably be expected for now -- or until the flaws of China's model become more apparent to its devotees. The economic crisis might provide convincing enough evidence, but only if it turns out that China's recovery lags behind or depends on that of the United States. In any event, true market-oriented reform in China must remain the United States' ultimate goal, and so the Obama administration must continue to push for the greater liberalization of China's economy. This will be like pulling teeth in the short term but will greatly speed up the process if and when Beijing is again open to market-oriented reform. Protectionism is not the answer. It would harm the United States too much, even if it harmed China more, and it would be a retreat from leadership. The U.S. government must demonstrate its continued leadership by displaying the confidence that it can thrive in competitive environments at home, on the global market, and in China itself.

Derek Scissors is a research fellow in Asia economic policy at the Heritage Foundation.

First Appeared in Foreign Affairs

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